Demand estimation and forecasting

Lecture (6)
Demand estmatation and Demand forcasting
• The demand estimating technique will be used by a manager interested
in probing the effect on the demand (or quantity demanded) of a
change in one or more of the independent variables.

• Forecasting puts less emphasis on explaining the specific causes of

demand changes and more on obtaining information regarding future
levels of sales activity, given the most likely assumptions about the
independent variables.
 Demand forecasting

What is forecasting?

Forecasting is a tool used for predicting

future demand based on
past demand information.
 Decisions that Need Forecasts

• Which markets to pursue( examine)?

• What products to produce?
• How many people to hire?
• How many units to purchase?
• How many units to produce?
• And so on……
 Common Characteristics of
Forecasting
• Forecasts are rarely perfect

• Forecast are more accurate for shorter than

longer time periods
 Forecasting Steps
• What needs to be forecast?
• units of analysis & time horizon required
• What data is available to evaluate?
• Identify needed data & whether it’s available
• Select and test the forecasting model
• ease of use & accuracy
• Generate the forecast
• Monitor forecast accuracy over time
What is forecasting all about?

Demand for Mercedes E Class We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months
Actual demand (past sales)
Predicted demand
 Why is forecasting important?
Demand for products and services is usually uncertain.
Forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost controls)
• Marketing (future sales, new products)
• Production and operations
 Types of Forecasting
There are two types of forecasting:
•Based on Economy
•Based on the time period
A. Based on Economy
There are three type of forecasting based on the economy:
1.Macro-level forecasting: It deals with the general economic
environment relating to the economy as measured by the Index of
Industrial Production(IIP), national income and general level of
employment etc.
2.Industry level forecasting: Industry level forecasting deals with the
demand for industry’s products as a whole. For example demand for
cement in India, demand for clothes in India etc.
3.Firm-level forecasting: It means forecasting the demand for a
particular firm’s product. For example, demand for Birla cement,
demand for Raymond clothes ,etc.
 Types of forecasting
.
B. Based on the Time Period
Forecasting based on time may be short-term forecasting and
long-term forecasting
1.Short-term forecasting: It covers a short period of time,
depending upon nature of the industry. It is done generally
for six months or less than one year. Short-term forecasting is
generally useful in tactical decisions.
2.Long-term forecasting: Long-term forecasts are for a
longer period )say, two to five years or more(. It gives
information for major strategic decisions of the firm. For
example, expansion of plant capacity, opening a new unit of
business etc.
 Methods of Forecasting
• Qualitative (technological) methods: Forecasts generated
subjectively by the forecaster
 Used when little data exist (New products-New technology)
 Involves intuition, experience

• Quantitative (statistical) methods: Forecasts generated

through mathematical modeling
 Used when situation is ‘stable’ and historical data exist (Existing
products- Current technology)
 Involves mathematical techniques
 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
 The Delphi Method
• The Delphi Method uses a panel of experts.
• Expert responses to a series of questionnaires are anonymous.
• Each round of questionnaires results in a median answer.
• process guides the group towards a consensus.
• In a Delphi study, the participants do not interact with one
another,
• Delphi technique is used today in business, education, and the
social sciences
 Quantitative
Methods

Time series Associative

models models
 Time series models
Time series models look at past patterns of data and attempt to
predict the future based upon the underlying patterns contained
within those data.

 Forecast based only on past values, no other variables

important.
 Assumes that factors influencing past and present will continue
influence in future
 Decomposition of a time Series

Trend Cyclical

Seasonal Random

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ILLUSTRATION OF TIME SERIES
DECOMPOSITION
 Components of Demand
Trend
component
Demand for product or service

Seasonal peaks

Actual demand line

Average demand over 4

years

Random variation
| | | |
1 2 3 4
Time (years)
Figure 4.1
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 Trend Component
 Persistent, overall upward or downward pattern
 Changes due to population, technology, age, culture, etc.
 Typically, several years duration

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 Seasonal Component

 Regular pattern of up and

down fluctuations
 Due to weather, customs,
etc.
 Occurs within a single year

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 Cyclical Component

 Repeating up and down

movements
 Affected by business cycle,
political, and economic factors
 Multiple years duration 0 5 10 15 20

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 Random Component
 Erratic, unsystematic, ‘residual’
fluctuations
 Due to random variation or
unforeseen events
 Short duration
and nonrepeating

M T W T F

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 Time series models
• There are several models that uses time series data; some of
them are very simple such as the Naïve approach (Assumes
demand in next period is the same as demand in most recent
period)
• e.g., If January sales were 68, then February sales will be 68
• Some other approaches are more complex (Uses the least
squares method to fit a straight line to the data)
 Linear regression in forecasting
Linear regression is based on
1. Fitting a straight line to data
2. Explaining the change in one variable through changes in other variables.

dependent variable = a + b  (independent variable)

By using linear regression, we are trying to explore which independent variables affect
the dependent variable
 Regression analysis
• Regression analysis: a procedure commonly used by economists to
estimate consumer demand with available data
• for example, Regression equation: linear, additive
eg: Y = a + b1X1 + b2X2 + b3X3 + b4X4

Y: dependent variable
a: constant value, y-intercept
Xn: independent variables, used to explain Y
bn: regression coefficients (measure impact of
independent variables)

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Prentice Hall.
 Regression analysis
• Interpreting the regression results:

coefficients:
• negative coefficient shows that as the independent variable (Xn) changes, the
variable (Y) changes in the opposite direction
• positive coefficient shows that as the independent variable (Xn) changes, the
dependent variable (Y) changes in the same direction
• magnitude of regression coefficients is a measure of elasticity of each variable

Chapter Five Copyright 2009 Pearson Education, Inc. Publishing as 26

Prentice Hall.
 Estimation of Demand Function
Six variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Taste patterns of consumers (  )
• Expected future price of product (Pe)
• Number of consumers in market (N)

• General demand function

• Qd  f ( P, M , PR , , Pe , N )
2-27
 General Demand Function
Qd  a  bP  cM  dPR  e   fPe  gN
• b, c, d, e, f, & g are slope parameters
• Sign of parameter shows how variable is related to Qd
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship

N.B: please see the word sheet attached with lecture 6 in blackboard.
 Linear least squares method
• The linear least squares fitting technique is the
simplest and most commonly applied form of
linear regression and provides a solution to the
problem of finding the best fitting straight line
through a set of points
 Trend Projections
Fitting a trend line to historical data points to project into the
medium to long-range
Linear trends can be found using the least squares technique

^
y = a + bx
^ where y = computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
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Least Squares Method
Values of Dependent Variable

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y = a +^bx

Time period Figure 4.4

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Least Squares Method
Least squares method minimizes the sum of the squared
Values of Dependent Variable errors (deviations)

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y = a +^bx

Time period Figure 4.4

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 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005 3 80 9 240
2006 4 90 16 360 The trend line is
2007 5 105 25 525 ^
y = 56.70 + 10.54x
2008 6 142 36 852
2009 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

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 Least Squares Example
Trend line,
160 – y^ = 56.70 + 10.54x
150 –
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
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 Associative Forecasting
Used when changes in one or more independent variables can be used
to predict the changes in the dependent variable

Most common technique is linear regression analysis

We apply this technique just as we did in the time

series example

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